Credit-Linked Notes: a look at structured finance tools
- F. Tamburrino; S. Colavecchia
- 22 mar
- Tempo di lettura: 13 min
A credit-linked note (CLN) is a financial instrument that allows the issuer to transfer specific credit risks to investors. It shares features with both bonds and credit default swaps (CDS). Specifically, it is a security with an embedded credit default swap that enables the issuer to shift credit risk to investors. CLNs are created through a special purpose vehicle (SPV) or trust, which is collateralized with AAA-rated securities. Investors purchase these notes from a trust that pays a fixed or floating coupon throughout the note's lifetime. As compensation for taking on specified credit risks, CLN investors typically receive a higher return rate compared to traditional bonds.
How do they function
Credit-Linked Notes (CLNs) are structured financial instruments designed to give investors exposure to the credit risk of a specific entity or group of entities, like corporations, governments, or financial institutions. The essence of a CLN is that it combines the features of a debt security with the added element of credit risk, which makes it different from conventional bonds.
When an investor buys a CLN, they are essentially lending money to the issuer of the note, which is typically a bank or another financial institution. The issuer agrees to pay the investor regular interest payments (coupons) over the life of the note, just like a typical bond. However, the crucial difference lies in the fact that the payout on the principal and the coupons is tied to the performance of an underlying reference entity. This reference entity is usually a company or a sovereign government, and its creditworthiness directly impacts the CLN.
The key feature of a CLN is the possibility of a credit event occurring with the reference entity. A credit event could be defined in various ways but generally refers to situations like defaults, bankruptcies, or other significant negative changes in the financial health of the reference entity. If such an event occurs, the CLN investor risks losing all or part of their principal. Essentially, the investor is taking on the credit risk of the reference entity in exchange for the potential reward of a higher return, typically in the form of the coupons, than they would receive from a traditional bond of similar maturity and quality.
To further elaborate, imagine a CLN where the reference entity is a corporation that is at risk of defaulting on its own debt. If the corporation suffers a credit event, the issuer of the CLN may not be able to return the full principal to the investor. In such a case, the investor would suffer a loss, which is reflective of the default or credit impairment of the corporation. On the other hand, if no credit event occurs by the maturity date of the CLN, the investor would receive the full return, including interest payments and principal.
The pricing of a CLN is generally influenced by the perceived credit risk of the reference entity. Investors will typically demand higher coupon rates if the reference entity is seen as riskier, meaning the likelihood of a credit event is higher. Conversely, for a reference entity with a low likelihood of experiencing a credit event, the CLN will offer lower returns, similar to a lower-risk bond.
The structure of the CLN also allows the issuer to hedge their exposure to the reference entity. For example, the issuer might use credit derivatives, like credit default swaps (CDS), to offset the risk they take on by issuing the CLN. This makes the CLN an instrument that effectively transfers the credit risk from one party (the issuer) to another (the investor). In this way, CLNs serve as a mechanism for risk transfer in the financial markets, allowing the issuer to offload exposure to the creditworthiness of a particular entity or a basket of entities.
When it comes to regulatory oversight, CLNs are treated as structured products and are subject to the same regulatory frameworks that govern other financial products, such as bonds and derivatives. The rules surrounding their issuance often require a detailed prospectus and regulatory approval, especially if they are sold to the public. These regulations aim to ensure that investors understand the risks involved and that issuers remain accountable for their obligations.
Overall, CLNs function as an instrument that provides access to credit risk in exchange for higher potential returns, while at the same time transferring the risk from the issuer to the investor. Their function is rooted in the interplay between bond-like structures and derivative-like credit exposure, making them a hybrid financial product.
How securities are rated
Just as individuals have credit reports and ratings issued by credit bureaus, bond issuers are evaluated by ratings agencies to assess their creditworthiness. A bond's rating is determined by the issuer's financial ability to make interest payments and repay the loan in full at maturity. This rating affects the yield the issuer must offer to attract investors.
Lower-rated bonds typically offer higher yields to compensate investors for the additional risk. Ratings agencies research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. Each agency uses a similar hierarchy to help investors assess a bond's credit quality compared to other bonds. Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on Moody's) or better are considered "investment-grade." Bonds with lower ratings are considered "speculative" and often referred to as "high-yield" or "junk" bonds. The three main ratings agencies in the US that evaluate bond creditworthiness are Moody's, Standard & Poor's, and Fitch. In the EU, bonds are rated by Fitch, Moody's, Scope, DBRS, KBRA, and S&P Global Ratings (which rates the EU as AA+). The EU is legally bound by the Treaty on the Functioning of the EU (Article 323) to service interest and principal payments to investors arising from the issuance of EU-Bills and EU-Bonds. EU borrowing is therefore a direct and unconditional obligation of the EU. EU-Bonds maintain the highest credit quality due to the backing of the EU budget and additional budgetary resources or guarantees that support various EU-funded programs. It's important to note that ratings also vary based on investment duration—for example, Fitch's highest rating for long-term investments is AAA, while for short-term investments it's F1+.
Contractual structure
The contractual structure of a Credit-Linked Note (CLN) is a carefully crafted agreement that sets out the relationship between the issuer, the investor, and the reference entity. At the heart of the structure is the issuer's obligation to pay the investor periodic interest (coupons) and return the principal at maturity, provided no credit event occurs with the reference entity. If a credit event affects the reference entity, the structure of the CLN allows for a loss of principal or a reduction in the amount repaid to the investor, depending on the severity of the event. The CLN contract defines the specific types of credit events that will trigger such a loss, along with how these events will be determined and how losses will be calculated.
In terms of payments, the investor receives regular coupon payments, which are typically higher than those of standard bonds to compensate for the additional credit risk. These payments continue unless a credit event disrupts them. The principal is expected to be returned to the investor at maturity, again, unless the reference entity experiences a credit event, in which case the investor may receive less or even lose part of the principal. The settlement of a credit event can either be through physical delivery of defaulted debt securities or through a cash settlement, where the investor is paid an amount based on the loss from the reference entity’s default.
The structure may also allow for early termination or redemption under certain conditions, such as if the reference entity's credit rating falls below a specified level or other adverse events occur. This gives flexibility to either party to adjust the terms based on changing financial conditions or risk profiles. All of these terms are carefully outlined in the contract, ensuring both the issuer and the investor understand their rights and obligations under various circumstances.
Regulatory Considerations
In Italy, Credit Linked Notes (CLN) are subject to regulation and oversight by several key authorities and legislative frameworks. These include the Bank of Italy, which provides central supervision; the Istituto per la Vigilanza sulle Assicurazioni (IVASS), responsible for insurance-related oversight; and the Commissione Nazionale per le Società e la Borsa (Consob), which supervises the securities market. In addition to these bodies, the Testo Unico della Finanza (TUF) and the Testo Unico Bancario (TUB) serve as the primary legislative texts that outline the rules and principles governing financial and banking activities in the country.
EU regulation
Markets in Financial Instruments Directive II (MiFID II) is a comprehensive regulatory framework that governs the use, application, and trading of financial instruments within the European Union. It aims to enhance transparency, strengthen investor protection, and improve the functioning of financial markets across member states.
Prospectus Regulation (EU) 2017/1129 outlines the requirements for issuers to provide a detailed prospectus when offering securities to the public or listing them on a regulated market. This prospectus must contain all critical information, enabling investors to make informed decisions by assessing the potential risks, expected returns, and overall viability of the financial instrument in question.
Capital Requirements Regulation (CRR) (EU) No 575/2013 establishes stringent prudential standards for credit institutions and investment firms operating within the EU. These requirements include detailed rules on capital adequacy, liquidity management, and risk mitigation practices, all aimed at ensuring the stability, solvency, and resilience of financial institutions.
The European Banking Authority (EBA) Single Rulebook, specifically Articles 218 and 332, sets forth precise regulatory obligations and guidelines that banking institutions within the EU must adhere to. These provisions form a unified framework designed to uphold financial stability, ensure a consistent application of banking standards, and foster trust across the European financial sector.
UK
Capital Requirements Regulation (CRR) → A core piece of European financial legislation that establishes detailed rules and requirements for financial institutions, aiming to promote stability within the banking sector by ensuring adequate capital buffers and risk management frameworks.
Financial Conduct Authority (FCA) → Operating as the UK's foremost financial regulatory entity, the FCA shoulders the responsibility of safeguarding market integrity by enforcing transparency, ensuring customers are treated fairly, and implementing robust mechanisms for the effective management of financial risks.
Prospectus Regulation (EU) 2017/1129, now part of UK law post-Brexit → This regulation mandates that issuers of securities provide thoroughly detailed and transparent information, enabling potential investors to make decisions that are well-informed and based on an accurate understanding of the risks and opportunities involved.
US
The regulatory environment surrounding Credit-Linked Notes (CLNs) plays a vital role in shaping their issuance and trading processes. Key regulations, notably the Dodd-Frank Act (Dodd-Frank Wall street Reform and Consumer Protection Act) and Basel III, have instituted comprehensive frameworks that govern the financial markets, subsequently impacting the attractiveness and functionality of CLNs. These regulations impose specific capital requirements and standards that institutions must adhere to while structuring these instruments, effectively influencing their sale and purchase in the market.
The Dodd-Frank Act, implemented following the 2008 financial crisis, aims to enhance transparency and accountability within the financial sector. This legislation introduces several mandates that directly affect the trading of Credit-Linked Notes. For instance, swap regulations necessitate that many derivative transactions—potentially relevant for CLNs—be conducted on regulated exchanges or through clearinghouses, ensuring a higher level of oversight. Consequently, issuers must navigate these complexities to secure compliance, which ultimately affects their operational strategies and cost structures.
Basel III further complicates the landscape by imposing stricter capital and liquidity requirements on banks and financial institutions. As banks are often active participants in the issuance of Credit-Linked Notes, compliance with these regulations can influence their risk appetite and willingness to engage in CLN transactions. The impact of Basel III’s focus on reducing systemic risk can lead to a more cautious approach from financial entities, potentially reducing the overall market liquidity for such instruments.
Moreover, compliance obligations are accompanied by significant challenges. Institutions must establish robust risk management frameworks and reporting mechanisms to satisfy regulatory scrutiny. This can result in increased operational costs and resource allocation towards compliance rather than innovation in product offerings. As such, both issuers and investors should remain vigilant about the evolving regulatory landscape, as it continues to shape not only the market for Credit-Linked Notes but also the broader financial ecosystem in which they operate.
Risk and advantages of CLN
Credit-Linked Notes (CLNs) present a unique investment opportunity that combines fixed-income instruments with credit exposure, offering several benefits for investors. One of the primary advantages is the potential for enhanced yields. CLNs generally provide higher interest payments compared to traditional bonds due to the credit risk associated with the underlying reference entity. This premium serves as an incentive for investors willing to assume the risk of default.
Another significant benefit is the ability to manage credit exposure. Investors can tailor CLNs to align with their desired risk profiles, allowing them to gain access to specific credit markets without directly purchasing the underlying debt instruments. This flexibility is particularly advantageous during volatile market conditions, as investors can strategically adjust their holdings based on credit outlooks or economic changes.
However, investing in CLNs is not without risks. Chief among these is credit risk, which entails the possibility that the reference entity may default on its obligations. Such events can lead to considerable financial losses for investors holding CLNs. Furthermore, market risk is prevalent, as fluctuations in interest rates or credit spreads can impact the value of CLNs. Investors must remain aware of changing market dynamics that could affect their investments.
Additionally, legal risk is a factor that cannot be overlooked. The complexity of the contractual agreements that govern CLNs necessitates comprehensive understanding and due diligence. Misinterpretation or lack of clarity in these agreements may expose investors to unforeseen liabilities or losses. Therefore, conducting thorough due diligence is crucial before committing to CLNs. By weighing the benefits against the inherent risks, investors can make informed decisions regarding their participation in this innovative financial instrument.
Future trends in CLNs
In recent years, Credit-Linked Notes (CLNs) have undergone significant evolution, adapting to the changing needs of the financial market. One notable development has been the increased use of Synthetic Risk Transfers (SRT), a financial technique that allows banks to transfer the credit risk of loan portfolios to investors such as insurance companies, hedge funds, and private credit funds. This practice has gained popularity in both Europe and the United States, especially after regulatory clarifications provided by the Federal Reserve in 2023. SRTs provide banks with the opportunity to reduce required regulatory capital, thus improving their financial position.
Additionally, the adoption of blockchain and cryptocurrencies has led to the exploration of tokenizing CLNs. This innovation aims to enhance liquidity, increase transparency, and reduce transaction costs, broadening the investor base and encouraging greater market participation. The combination of CLNs and blockchain technology represents a step toward the modernization of financial markets, offering more efficient and accessible solutions.
Simultaneously, there is a growing focus on Environmental, Social, and Governance (ESG) factors. Investors are increasingly demanding that financial products, including CLNs, align with sustainability goals. This shift has led issuers to incorporate ESG criteria into CLN structures, resulting in the creation of indices that reflect these metrics and integrating sustainability into the investment process.
At the regulatory level, authorities are reviewing existing regulations in response to market innovations and emerging risks. In the United States, the Federal Reserve has provided clarifications on the use of CLNs to transfer credit risk and offer capital relief to banks. These regulatory developments are influencing the structuring of CLNs, creating opportunities for greater compliance and investor protection.
In summary, CLNs are evolving through the integration of new technologies, the adoption of ESG criteria, and adjustments to regulatory changes. These shifts are transforming the financial landscape, providing more sophisticated instruments that are better aligned with the modern needs of investors.
Example: how a CLN effectively works
Let’s take into consideration a CLC having as reference entity a specific company. The certificate is issued March 19th 2025 with an issue price of 200 EUR, 5 year duration and an annual prize of 10 euros. If a credit event was to happen, the minimum payment upon expiration is 50% of the issue value of the Certificate. Here are the possible scenarios for the investor.
No credit event:
● 19 March 2026: the investor receives 10 €;
● 19 March 2027: the investor receives another payment of 10 €;
● 19 March 2028: the investor receives 10 €;
● 19 March 2029: the investor receives 10 €;
● 19 March 2030: the investor receives 10 euro plus refund of 200 euro, equal as the issue value of the certificate.
Credit event third year:
● 19 March 2026: the investor receives 6 €;
● 19 March 2027: the investor receives 6 €;
● 19 March 2028: no payment due to credit event;
● 19 March 2029: no payment;
● 19 March 2030: the investor receives 100 euro, equal to 50% of the issue price
Credit Event first year
● 19 March 2026: no payment due to credit event;
● 19 March 2027: no payment;
● 19 March 2028: no payment;
● 19 March 2029: no payment;
● 19 March 2030: the investor receives 100 euro, equal to 50% of the issue price.
Glossary
What is a bond ?
A bond represents a debt obligation where one party (the issuer) borrows money from another party (the bondholder) and agrees to repay the principal with interest according to specific terms. In simple terms, buying a bond (called "obbligazioni" in Italian) is like lending money to a company (corporate bond), municipality (municipality bond), or most commonly, a country. In exchange, you receive regular interest payments (coupons) over a long-term period, usually 10 years. When the bond reaches maturity, you can redeem your initial investment. Bonds can be held or traded. The interest rate, called the coupon, is typically fixed and paid twice yearly, making it less volatile.
Yield: This is a measure of interest that accounts for the bond's fluctuating value. While there are several ways to measure yield, the simplest is dividing the bond's coupon by its current price.
Face value: This is the amount the bond is worth when issued, also known as "par" value.
What is a Credit default swap (CDs)
CDs are financial derivatives that function as a type of insurance against the risk of default on debt securities, such as bonds or loans. It can be thought of as insurance against credit risk. In a CDS agreement, the buyer pays periodic premiums to the seller in exchange for compensation if the underlying debt issuer defaults or experiences a credit event, like a downgrade. So a CDs is a way to ensure an investment in case of default, so when the issuer is not able to fulfill the obligation the investor is covered in exchange of a portion of the profit made by the coupon
What is a SPV
A company whose sole object is the purchase of loans or other financial assets sold by banks or other intermediaries (originators) and which, in return for these transactions, issues marketable securities. Special purpose vehicles report to the Risk Management Centre (CR) loans and guarantees purchased if they were already reported by the originators. This means that, in the event of a sale of your own funding, you can find in CR an account report from the special purpose vehicle to which the funding was sold, rather than from the bank that originally provided it. In this case the client has no contact with the special purpose vehicle, but with so-called servicers, specialized intermediaries to whom the special purpose vehicles entrust the collection of funds. For information or disputes, the customer can contact the service provider and the special purpose vehicle.
Bibliography
https://www.investopedia.com/terms/c/creditlinkednote.asp#:~:text=A%20credit%2Dlinked%20note%20(CLN)%20is%20a%20security%20with,collateralized%20with%20AAA%2Drated%20securities.
https://commission.europa.eu/strategy-and-policy/eu-budget/eu-borrower-investor-relations/eu-credit-strength_en#:~:text=The%20EU%20is%20rated%20AAA,AA%2B%20by%20S%26P%20Global%20Ratings.
https://www.barbicanconsulting.co.uk/insights/credit-linked-notes#:~:text=A%20CLN%20is%20normally%20a,known%20as%20the%20reference%20entity.
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